How to analyse operating margin?

It has always been a difficult task for retail investors to understand balance sheets and analyse stocks without depending on a broker and a research firm. We did a series of articles on how to identify stocks keeping in mind the sector growth and concerns (Click here to read the special reports).

It is now time to focus on 'how to go about analyzing stocks?' This is the first part to the series of article on 'how to analyse the balance sheet?' Since we intend to simplify, it may be a bit lengthy.

We start with Operating Profit, one of the most commonly referred parameter. How does a business make profit? Simply put, profits equal revenues minus the cost incurred to achieve that revenue. There are two broader aspects here.

As far as costs are concerned, there are operating costs like say, raw materials, salaries, administration expenses, selling and marketing. There are also costs like interest payable on the debt borrowed, depreciation on fixed assets and tax charges on the profits generated, which are post the operating level.

Since we are discussing about operating margins, Operating Profit = Net Sales - Operating Costs, which means: Operating Margin = (Net Sales - Operating Costs) divided by Net sales, wherein Net Sales equals Gross Sales less Excise duty.

While it is easy to calculate the operating margin, the general questions in investors' mind are:

1. How does one ascertain whether a given operating margin is good or bad?
2. Why do some companies in the same sector have higher operating margins than others?
3. Why do companies in some sector have higher operating margin than others?

The sales side

To understand the same, let us begin with the Sales side, as there are two parts to operating profit, as is evident from the formula above. Sales, as you may know, is number of units sold multiplied by price per unit.

Now, why are we going into all these factors? The reason is, for operating margin to increase, the difference between sales and cost has to increase. So, if a company is able to sell a given quantity at a higher price without a corresponding increase in expenses, margins are likely to expand.

The following real example of Tisco will strengthen our argument.

In the case of Tisco…

While quantity of steel sold by Tisco in FY03 increased 27%, price at which each unit was sold increased by 17%. Backed by this, total sales grew at 30%, but operating expenses grew at a much slower rate of 18%, resulting in a sharp expansion of operating margin. But consider the following example that shows a different picture.

In the case of Hero Honda…

Despite a 3% fall in realisation, Hero Honda managed to improve operating margins significantly in FY03 to 17%. This is because the number of units sold rose at a faster rate of 18% as compared to the expenditure. This enabled the company to improve margins.

So, not only is the performance on the sales side important, but also control over expenditure. This brings us to the second aspect that has a say in operating margin viz. operating expenses.

Expense side

Some of the major or critical operating expenses are that of raw materials, employee cost, selling and distribution, advertising, administration and other expenses. The importance of each cost varies depending on sector to sector. For example, for commodity companies, freight and power costs are extremely critical, whereas advertising costs are higher for FMCG companies. For paint majors, control over raw material costs is extremely important.

However, we would like to simplify this cost factor by dividing costs into two broader aspects viz. Fixed Cost and Variable Cost. Before going any further, consider the following example.   Costs behaviour for capital intensive sector…*

The above table clearly brings forth the behavior of fixed and variable costs for a capital-intensive sector like cement when sales is gaining momentum. Though sales rose by 20% in FY03 and fixed costs remained the same, operating margins rose at a faster rate on account of a less than proportionate rise in variable cost. This is almost equivalent to the Tisco example above.

However, for an FMCG major, even if sales increases at a faster rate, the company has to spend more on raw material, advertising and promotion. This result is a slower expansion in operating margin as compared to a capital-intensive company in an upturn. To make this task even simpler for a retail investor, we have listed the sectors with high fixed and low variable cost.   In short…

Finally and more importantly, a company's or a sector's operating margin behavior could be judged if a retail investor is able to understand the table below. This is Michael Porter's path breaking competitive model. Do not be swayed away by the name, it is very simple to understand.

Without going into complexities, it is pertinent for a retail investor to pen down his view on a sector and on a particular company where he is interested to invest his money. In the table above, we have put our view on the FMCG sector as a whole and HLL's position within that. You could do the same for other sectors.

1. Demand – What is the demand growth prospects for the sector? If it is good, how much is the company's market share in the sector?
   
2. Supply – Remember, it is a competitive environment and no player can have a monopoly in the long term. If you believe that supply will outstrip demand, prices could come under pressure so as to maintain sales growth. A favorable demand-supply equation generally results in better pricing power, which in turn results in higher operating margin.
   
3. Barriers to entry – How easy or difficult is it for a new player to enter a sector? What is the skill set required? If a sector has a lower entry barrier (like call centres), margins will fall due to stiff competition. It is not easy to make airplanes, but it is relatively easy to make soaps and detergents.
   
4. Bargaining power of customers – What is the choice level for a customer? Why should a customer buy a product of a company and why not from the competition? If the bargaining power of customer is high (like in FMCG and auto), margins will decline over a period of time from their peaks.
   
5. Bargaining power of suppliers – Suppliers are usually raw material manufacturers or traders. If a company has high capacity (like auto majors), the bargaining power of suppliers tends to be lower (like auto ancillary companies).
   
6. Competition – What is the level of competition in the sector viz. domestic and international? Even if there is competition, is the company's product unique by any means (like Boeing and Airbus). If it is, then the company has an edge.

To conclude, while valuing a company, the importance of operating margin cannot be understated, as it will to an extent, indicate the competitive position of a company. A company with a superior margin profile will command a premium, unless this high margin profile is under threat.

Remember, the quality is more important that quantity of earnings. And operating margin is one of the vital indicators of the quality of earnings. Happy investing!

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